I am a Tax Partner in WithumSmith+Brown’s National Tax Service Group and the founding father of the firm's Aspen, Colorado office. I am a CPA licensed in Colorado and New Jersey, and hold a Masters in Taxation from the University of Denver. My specialty is corporate and partnership taxation, with an emphasis on complex mergers and acquisitions structuring. In the past year, I co-authored CCH's "CCH Expert Treatise Library: Corporations Filing Consolidated Returns," was awarded the Tax Adviser's "Best Article Award" for a piece titled "S Corporation Shareholder Compensation: How Much is Enough?" and was named to the CPA Practice Advisor's "40 Under 40."

In my free time, I enjoy driving around in a van with my dog Maci, solving mysteries. I have been known to finish the New York Times Sunday crossword puzzle in less than 7 minutes, only to go back and do it again using only synonyms. I invented wool, but am so modest I allow sheep to take the credit. Dabbling in the culinary arts, I have won every Chili Cook-Off I ever entered, and several I haven’t. Lastly, and perhaps most notably, I once sang the national anthem at a World Series baseball game, though I was not in the vicinity of the microphone at the time.

The Fiscal Cliff For Dummies, Part 2: The Economic Implications Of Extending The Bush Tax Cuts

U.S. Speaker of the House Rep. John Boehner (R-OH) addresses the media during a press conference in the U.S. Capitol building November 9, 2012 in Washington, DC.

Late last week, President Obama and House Speaker John Boehner began what promises to be two months of political posturing — and much less likely, meaningful negotiation — geared towards avoiding the impending “fiscal cliff.” I wrote about this much-discussed but little-understood cliff in the past, but now that the President has won reelection and Mitt Romney’s promised extension of the Bush tax cuts, elimination of the AMT, and removal of Obamacare are off the table, the fiscal cliff looms as a much more likely reality.

What follows is a detailed discussion of the cliff and its ancillary economic impacts. Let’s get to the Q&A:

Q: In your last post on the topic, you defined the fiscal cliff as “the convergence of two events on December 31, 2012 — the expiration of almost every tax cut enacted since 2001 and a scheduled reduction in government spending — that, if the experts are to be believed, when taken together will threaten to bankrupt America, shift the world balance of power, and knock Earth off its orbit, sending it hurtling through cold, dark space.”

While moderately entertaining, that definition didn’t really explain a whole lot. Can you help me understand how reduced spending and increased revenue could be a bad thing in light of our current deficit?

A: Sure. While going over the cliff would improve our current deficit by adding net inflows, according to the people who are paid to project this sort of thing, real GDP will drop by 0.5% in 2013 — meaning we would experience negative growth — and unemployment will rise to 9.1%. In other words, the fiscal cliff will kick-start a recession. The reasons why depend on which component of the cliff we’re talking about: the reduced spending or the increased tax revenue.

Q: Man, I’m still confused. Let’s start with the spending cuts….are they tied to the tax increases or are these two independent events?

A: It’s a little bit of both. While the timing of the two events are coincidental, there is no denying that at a minimum, the required spending cuts are indirectly related to the expiring tax cuts in the sense that the foregone revenue resulting from the cuts contributed to our bloated deficit, which in turn contributed to our need to cut spending. More directly, however, the changes in governmental spending are the result of the “debt ceiling crisis” of August 2011.

Q: I sort of remember that, but I was really preoccupied with the 4th season of “Jersey Shore” that summer. Can you fill in the gaps?

A: Sure. When the government wants to build a bridge, wage a war, or pick up some extra padlocks for Area 51, they need a way to finance the expenditure. In general, these funds come from one of two sources: tax revenue or borrowings.

For a number of years, the government has spent significantly more than it collected in tax revenue, forcing it to borrow the excess. And as you might imagine, consistently growing deficits and debt are a rather bad thing. Higher debt leads to a reduction in national savings, undermines investor and consumer confidence, and jeopardizes the government’s ability to continue to borrow at reasonable interest rates. Take these things together, and a fiscal crisis like the one experienced in Greece becomes a distinct possibility.

In light of these potential consequences, we can’t allow Congress to run amuck with the ol’ corporate credit card. As a result, there is a maximum amount of debt that can be incurred by the government, and this maximum is often referred to as the debt ceiling. During the summer of 2011, years of rampant spending finally caught up with the government, because it maxed out its borrowing capacity and run up against this debt ceiling.

Q: That sort of rings a bell. But we took care of all that, right? By the way, Season 4 was hilarious.

A: We did, but only in the most “U.S. government” sort of way. Rather than risk defaulting on our existing debt, we decided to raise the debt ceiling. Yes, you read that right….the government essentially punished itself for spending too much by increasing its ability to spend. Sound fiscal policy, right there.

But because Congress rightfully doesn’t trust itself, it built in a safety measure in the form of a bi-partisan “super-committee” — which isn’t nearly as cool as it sounds — that was charged with finding a way to cut $1.5 trillion off the national deficit over the next decade. In the event the committee failed to reach an agreement by November 2011, required spending cuts would kick in effective January 1, 2013, in an effort to slim our deficit and reduce our need for future debt. November came and went, and no agreement was reached. So here we are.

Q: Got it. So that’s where the spending cuts come in?

A: That’s right. And that’s also why I said that the expiring Bush tax cuts were indirectly responsible for the required reduction in governmental spending. The tax cuts reduced rates and expanded credits, which obviously reduced tax revenue and in turn drove up the deficit and the government’s need to borrow.

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Chimo you are ignorant. You need an education, instead of coming up with the craziest and dumbest stuff I’ve ever read. Free stuff? You mean like the gov’t assistance to most of the south and people like you Chimo. Miss, Alabama, LA, Arkansas, Kentucky, Tennessee, WV don’t raise enough state tax revenue. They are the states that get the most federal government aid. Look it up. The red states have the lowest per capita. highest illiteracy rate, worst educational systems, and the most people in the US that derive food stamps. These are all Romney supporters, not Obama people. The blue states pay far more in taxes, and they literally support you Chimo. The blue states have better jobs, higher employment. So when you say people don’t want to get jobs, you’re not talking about California or New York, because these states pay far more in taxes than the red states. Far more in taxes than you do Chimo. Read a book once in a while.

I have my doubts about the coming recession. After all, the tax increases in the 1993 Clinton economic program were bigger, and occurred just priot to a major economic expansion. I think that it would be a mistake to treat the “fiscal cliff” as an emergency. Let the tax cuts expire – all of them – and then tweak the tax system over the next year. The spending cuts should probably be spread out over a couple of years, though. As for the recession – I’m not seeing how a .5% drop in GDP ==> a 1% increase in unemployment.

The reason we didn’t have a negative economic impact was from the Clinton tax whopper was a) the internet forced businesses to spend, b) oil prices came crashing down.

Also the Clinton tax increases raises the bracket rates but lowered capital gains taxes which for many rich people offset the impact. In effect we made Lady Gaga pay more taxes but let people that invested keep more of their gains so they could invest more and make even more money. Notice how the really rich keep wanting to become even richer, i.e. continue to invest and not hide their money in some vault?

JOHN F. KENNEDY: “Our true choice is not between tax reduction on the one hand and the avoidance of large federal deficits on the other. It is increasingly clear that no matter what party is in power, so long as our national security needs keep rising, an economy hampered by restrictive tax rates will never produce enough revenues to balance our budget, just as it will never produce enough jobs or enough profits. Surely the lesson of the last decade is that budget deficits are caused by slow economic growth and periodic recessions, and any new recession would break all deficit records. In short, it is a paradoxical truth that tax rates are too high today and tax revenues are too low. And the soundest way to raise the revenues in the long run is to cut the tax rates now. When consumers purchase more goods, plants use more of their capacity, men are hired instead of laid off, investment increases, and profits are high. Corporate tax rates must also be cut to increase incentives and the availability of investment capital. “

kathy dunagan – The difference being that the highest marginal tax rate at the time was 91% and Kennedy wanted to cut it to 65%. And, by modern standards, the national debt was negligible. Now, the upper marginal rate is 35%. If the Bush tax cut is allowed to expire, the highest rate will become 39%, where it was prior to Bush’s cuts. Currently, the government is not collecting enough tax revenue to balance the budget even at full employment.

dallas, go check the data some time, you will be surprised that the rich today pay a much larger % of the income taxes than the rich back in your 91% glory days. In fact, the rich in the US pay the HIGHEST percentage of the income taxes levied when compared to any other modern economy. It is educational to look at actual tax revenues generated sometime.

Thanks for this clear description of the main fearmongering topic of pundits for weeks.

Possibly, only accountants ever see the annual IRS pie charts of revenue and expenditure, published in the 1040 Instructions. If all Americans had exposure to it, maybe we wouldn’t have reached this point fiscally. The amazing thing is that LBJ’s programs are the culprit. Those costs were at the state and local level prior to 1965, and if Washington could gradually shift them back, it might save us from our future of either hyperinflation, stagflation or outright default.

One other issue with this discussion is GDP does not equal long term wealth. Yes a drop in GDP is bad, all else the same, but all else is never the same. Is the GDP being put to productive social use?

Building bridges to nowhere bumps GDP as much as digging holes and filling them back in. Neither does as much good for the country as simply not spending that money in the first place. Rebuilding bridges that really don’t need it has a similar effect.

Maybe it’s better to keep 99 week unemployment for a short term then committing to digging holes and filling them back in for a long term.